Former Bundesbank Head Explains The Lull Before The VIX Storm

When the governing council of the European Central Bank meets in Frankfurt on Thursday, it is widely expected to announce a loosening in policy – most likely a cut in both the refinancing and deposit rates. Two weeks later, the US Federal Reserve will probably respond to strengthening economic data by moving in the opposite direction, tapering the pace of quantitative easing for the fifth consecutive meeting. This is another sign of how monetary policy is diverging in the two largest economies, a trend that is set to shape funding markets for years to come.

In the US, output is set to rebound in the second quarter after having been disrupted by dismal weather in the first. And while price rises have been subdued so far, employment surveys suggest an emerging skills shortage and thus the potential for wage cost growth that could help lift inflation close to the Fed’s 2 per cent target. By any measure the labour market is tighter in America than in Europe, where the recovery remains weak and uneven despite buoyant financial markets. The gap between actual and potential output will barely shrink in the eurozone this year, and unemployment will remain close to a record high.

Before long, these divergent fortunes are bound to lead to large differences in policy. In the US, interest rates could begin to rise in 2015. In Europe, they are likely to stay low for much longer.

One might expect that movements in financial markets would reflect these expectations. However, so far, by and large, they have not. The dollar has been ailing for months, defying analysts’ expectations that the currency would strengthen in anticipation of higher US interest rates. What is going on?

The answer is that market expectations seem to count less than current conditions, which still support the euro. First, the high yields on government debt in countries such as Italy and Spain have made them an attractive investment for believers in the ECB’s pledge to do “whatever it takes” to save the euro. Second, America’s shrinking pension deficits may have stoked appetite among pension-fund managers to lock in profits and match liabilities, helping suppress long-term bond yields. And then there are the central banks. The Eurosystem’s balance sheet has been shrinking for more than a year, as banks that borrowed from the central bank under the longer-term refinancing operation (LTRO) have repaid their debts early. Meanwhile, the Fed’s balance sheet is still growing, albeit at a reduced rate.

However, these factors are temporary. LTRO repayments are coming to an end, US quantitative easing will be completed by the end of the year, five-year government bond yields in Spain are already similar to those in America and long-dated US government bond yields are pricing in unrealistically low expectations of future economic growth. Diverging monetary policy will soon begin to have more impact.

To my mind, investors should prepare for more volatility this year. The degree of easing of US monetary policy has been exceptional. The tightening, when it begins, will also be unprecedented. The tightening has not yet begun – the Fed’s balance sheet is still expanding. I see significant potential for volatility and setbacks on financial markets over the next few quarters.

In particular, the story is not over for emerging-market countries that rely on cheap dollar funding. The recovery of their stock markets and currencies in the past months does not reflect improved economic fundamentals, but a better mood among investors. These countries are still vulnerable. When US interest rates begin to rise, these borrowers may be able to turn to euro-denominated debt as an alternative source of cheap financing. However, this at best delays adjustment; improving fundamentals remains urgent.

The Fed’s balance sheet, which was about half the size of the Eurosystem’s going into the crisis, has now overtaken its European counterpart as a proportion of output. Emerging markets will not be the only ones to suffer when this trend goes into reverse. A tightening in US monetary policy always causes fallout. This time will be no different. In fact, it may be worse, since the tightening starts from extremely expansionary territory.

the banks are hot house flowers under zirp and the fed buying all their bad paper. the banks are sitting back and buying stocks and everything else and are uninterested in re-raping we the people with debt. when the fed stops, if they can, the banks will get back into the lending game in a big way soaring interest rates, a falling stock market, and raging inflation will ensue. since we are toppy sitting back and waiting for the ball to come to you sounds like the prudent course to take for all of us future victims of the central bank.

BTW, I disagree on the author's overly optimistic forecasts on US economic recovery and thereby forcing the Fed hand to increase rates and accelerate tapering. The graph is an accurate warning though. Complacency means lacking anticipation. Low VIX means lacking anticipation. Should the Fed be able to ecape that corner it painted itself into, it creates a real risk of repeating history. Stock market crashes by their very definition are not anticipated by the market majority.

In any case my original point centres around the idea that the Fed has created a liquidity glut that makes fundamentals irrelevant and creates a stagnant price plateau that only panicked market participants can disturb. Observing market participant expectations is therefore quite relevant in my opinion.

"By any measure the labour market is tighter in America than in Europe, where the recovery remains weak and uneven despite buoyant financial markets. "

What in the world are these people smoking? The labor markets are tight int the U.S? Tell that to the 47 million people on SNAP. And the millions on unemployment. As for the rate hike in 2015 I'll remind them of this little ditty:

I know summer markets are generally slow but this market is grinding to a halt as it looks like nearly no one is actually trading. Thanks Bernanke and now Yellen you have screwed an entire generation of savers on top of it for this outcome.

wouldnt be surprised if the spoos creeps up and vix creeps down all the way till next election, bearish economic news notwithstanding. Watch fedres keep pounding that square peg of fabricated financial absurdity into the round hole of reason while the clueless sheeple proclaim 'wow, that dude with the sledge hammer looks pretty buffed.. maybe hes a model or something'

It's not a question of time if you've become another Japan.How about a lost decade.America is no different.You're broke.Interest rates can never rise because there's no tax base to support the 17.5 trillion deficit.If you raise interest rates you'll kill the job market for good and make it more expensive for small and medium sized business.That means massive layoffs.If you want to extend the current depression it's a good thing to do,raise interest rates.So.where's the Government going to get its' money from in order to support the right wing neo-cons in the State Department?It seems that they're in charge and have taken over policy in order to find ways to destroy the U.S. monetary system.You must lead the neo-con controlled Puppet says.So, now it will be another wasted trillion dollars or two moving U.S. toops into eastern Europe for another pretend cold war which will mean absolutely nothing to Russia except to see the U.S. continue to up their debts.Anything to bankrupt America.Just continue on the current path of neo-conizm.